Wednesday, February 10, 2010

This chart should not be interpreted scientifically. It is my interpretation of what the yield on 10-year Treasury bonds reveals about the market's outlook for U.S. economic growth. It's subjective, but I think it fits with a lot of the evidence that I follow. Today it's saying that the market believes the U.S. economy is growing at a relatively unimpressive pace; the consensus of most forecasters seems to be somewhere around 2-2.5%. If yields move above 4% this will be a good sign that optimism is returning. At 5%, the bond market would be telling us that we're in for a decent recovery, which would imply growth of 4% or more. I expect to see yields moving up to at least 4.5% this year, which would be consistent with growth expectations of 3-4%.

5 comments:

Dear ScottI would like to know more deeply your view regarding the sustainability of the recovery. I just read what Mr Faber said concerning a slump of Chinese economy and consequent impact on the metals commodities. He is optimistic on the grains. and this is to me a paradox. If oil and metals drop grains do the same...I share your optimism on the L-T basis but 2010 I am little confusedthank youp

I think we are in a sustainable recovery, but if China were to hit an air pocket then undoubtedly that could throw us off track for awhile. But I don't see the source of a serious slump anywhere right now. Monetary policy is easy, and the threat of higher tax rates is receding; the worst thing that could happen would be a big increase in tax rates, but markets have worried about that for the past year and now the political winds are shifting and are more supportive of spending cuts than of tax hikes. The fundamentals in the financial markets (liquidity, swap spreads, implied volatility) are back to something approximating "normal." Labor is much more productive, and this should lead to net job gains for the balance of the year.

The 10-year Treasury signal makes sense. Is it because investors are moving from low risk Treasuries to risk securities--corp bonds and stocks? Treasury prices then fall and corp bonds and stocks rise? Does a corp bond chart show that in the past?

When I see Treasury yields rising I equate it with inflation fears--but typically later in the cycle, believing growth doesn't cause inflation. However, sometime in the cycle the Fed keeps money too loose and T's will eventually price that.

Help me understand the chart with the mix of a better economy helping corp bonds and stocks and the inflation signal.

Tal: excuse the delay in responding. One, the stomach flu caught up with me; two, it's not an easy question to answer.

I think that as investors see the economy doing better it would be quite natural for Treasury yields to rise while corporate yields either hold steady or decline (spreads tighten in either case).

I think Treasury yields would have to rise if growth expectations increase. You might argue (as Brian Wesbury does) that 5- or 10-yr Treasury yields must over time be similar to the growth of nominal GDP. If nominal GDP is going to be 5%, why would you accept only 3.5% from Treasuries? You could buy just about anything tied to the economy (stocks) and expect something like 5% in return.

You also might argue that TIPS real yields should be close to the market's expectation for real growth. And the difference between TIPS and Treasury yields should approximate the market's inflation expectations.

Today TIPS are 1-1.5%, a little below the 2-2.5% consensus for growth. That's a good sign that the market is not only pessimistic about growth but also so worried about growth that it is willing to forego real yield.

Treasuries are 2.5-3.7%, which would make sense using the Wesbury rule only if inflation were zero. I think this also reflects deep pessimism plus a willingness to pay a premium for safety and security.